Bubbles, Banks & Builders: Pt.III - "Do or Die, Bed Stuy"

There is this section of Brooklyn known as “Do or Die, Bed Stuy,” named for the rough and tumble character that was needed to survive it was known for back in the days (due to the housing boom, it is now gentrifying). Well, it’s time to invoke the call of the ‘Stuy here. This quarter is “Do or Die” time for the home builders, and without a real fight to survive, someone will be announcing bankruptcy by year end. Actually, someone will be annoucing soon anyway, it is just a matter of who has the least fight left in them. What’s funny is that their stock just might rally right up to the bankruptcy announcement just in time for those sell side analyst following investors to lose all of their money, right Mr. Kim from Citibank! Maybe Citibank’s research department should pay me for this blog’s research! Click the image below, if you need to enlarge it.

This is an analysis of the probability of Lennar Corp going bankrupt. It uses the multivariate formulae derived from the work of Edward I. Altman, a financial economist and professor at the Leonard N. Stern School of Business at New York University. His work has an impressive pedigree for accuracy as a measurement of the financial health of a company and is a powerful diagnostic tool that forecasts the probability of a company entering bankruptcy within a 2 year period. Studies measuring the effectiveness of his work have shown that the model has 70%-80% reliability. Notice I said “within” a 2 year period, and not necessarily 2 years. There is a substantial difference in the subtle semantics. Lennar could conceivably go bankrupt in the next few quarters! They are currently running at negative cash flow, in an increasingly negative operating environment. What does that mean? It means the banks will run on all of the other marginal builders, massive amounts of debt will get devalued (further), and land values will plummet even harder due to inventories being written down in order to compete with whoever bought the bankrupt builder’s already distressed assets for mere fractions of a penny on the dollar. This will make the not so marginal builders more marginal because there debt will be under more scrutiny and their inventory will be worth even less. This will then bounce back to the banks holding the REOs (trust me, there are a lot) and the existing homeowners trying to sell.

Lennar is the largest of the US homebuilders by revenue, and is by far not the one in the worst condition. I am attempting to make a point here by illustrating that the largest homebuilder who is far from being at the bottom of the bankruptcy pile is still dangerously close to being able to wear the B word. It is all about liquidity and cash. The builders, in general, just don’t have any. Many think that some of the builders who have sold off assets have a better go at it, and they do – but many of them are burning cash through operating losses fast enough to eat up all of the cash they raised before the market turns – for it is not going to turn any time soon.

Back to the original point, Altman's equation did a good job at distinguishing bankrupt and non-bankrupt firms.

Zones of Discrimination:

Score - Probability of Business Failure

1.8 or less - Very high (72% or higher)

1.81 to 2.99 – Grey Area, Unable to Determine with 90% confidence, but scores below 2.7 are considered “At Risk”. A random sample of companies revealed 94% had scores less than 2.7 before they went bankrupt. In contrast, 97% of the non-bankrupt firms had Z scores above this level. Lennar’s score is currently 1.84 and is deteriorating more than .25 points per quarter with REOs in its main profit (and loss) areas increasing at roughly 5%-10% PER WEEK! They just reported the worst quarterly loss in their 52 week history. Despite this, analysts are trying to call a bottom and the stocks have rallied roughly 20% in one week (click this link to see the “common sense” post).

3.0 or more - Very low

To make matters worse, the conditions that have brought about this rapid deterioration in the buider’s operating environment are now significantly exacerbated. See: “Bubbles, Banks and Builders”, then “Bubbles, Banks, and Builders, Pt. Deux”, and for a background on how all of this came about see “For those who feel the world has decoupled from the US economically - and in the financial markets, I bring you “The Great Global Macro Experiment” and then “Thoughts on the US Publicly Traded Homebuilders” and “Correction, and further thoughts on the topic”. Wheww! That’s a lot of homework, isn’t it? Now you know how your kids feelJ

These numbers on Lennar or open to revision, since I need to review them. I will maintain a Builder Bust List to show exactly how bad these companies currently have it, who will be most likely to go and when, and more so to show how foolish it is to attempt to bid them up or even try and by them now. In the case of a bankruptcy, the equity holders usually get zero, zilch, nada! Now if you bought this stock and got caught in a bankruptcy filing, you honestly can’t say that you didn’t see the writing on the wall. If anything, it was graffiti everywhere.

Lennar Reports Third Quarter Results Highlights

	•		Revenues of $2.3 billion – down 44%
	•		Loss per share of $3.25 (includes a $3.33 per share charge related to valuation adjustments and write-offs of option deposits and pre-acquisition costs, goodwill and financial services notes receivable)
	•		Homebuilding operating loss of $787.7 million (includes $847.5 million of homebuilding valuation adjustments and write-offs noted above). These adjustments will be far from the last. See the links above for the REO growth rate in Lennar’s key markets. These massive writedowns should have started earlier, but probably didn’t in order for upper management to preserve ’06 year end bonuses based on asset growth (not profitability, which would have aligned management’s interest with the shareholders and bondholders – a misguided compensation system in the homebuilding industry).
	•		Financial Services operating loss of $5.2 million (includes $9.3 million of write-offs of notes receivable). This write down tells more than appears on the surface. As detailed in “Thoughts on the US Publicly Traded Homebuilders”, most of the public builders are going to get stuck with the same liquidity problems that plagued Countrywide, American Home Lending, and all of the other non-bank mortgage lenders. There funding liquidity dried up at the same time that the market for their product dried up. That not only means that they can no longer sell product, but that they are stuck with mortgage inventory on their books with short term funding. Because this stuff was poorly underwritten, much of it went bad or is going bad. Reference the rampant REOs in the Bubbles, Banks and Builders” (now you can begin to see how all of this stuff is connected), The prospect of being stuck with bad mortgages on a dying credit line produces much more than a $9.3 million problem for Lennar, who wrote more mortgages than all of the builders and most mortgage banks. Expect this problem to crop up again in the future with larger numbers and bigger problems. Look at what its doing to Countrywide!
	•		Homebuilding debt decreased $212.8 million; homebuilding debt to total capital of 33.5%. Better, but still not good.
	•		Deliveries of 7,636 homes – down 41%
	•		New orders of 5,804 homes – down 48%; cancellation rate of 32%. This is less than the existing (and overstated) backlog, which is very bad. ·         Lennar was forced to renegotiate its credit line to avoid default
			Digging deeper into the Lennar’s numbers to find the TRUTH Backlog dollar value of $2.2 billion – down 60%. In the links above, I explain how the stated back orders cannot and will not be fully realized and are thus overstated. In addition, this number is dreadful for THIS builder. It claims a backlog 6,367 homes (overstated since it does not take into account the tightened mortgage market), yet only had quarterly closings of 7,636. The only way left (mortgage financing is now a risky loss engine) for the homebuilders to generate cash is to sell off their inventory, which (unlike Hovnanian’s representations) means actual closings. Lennar is running out of people to sell to, hence is running out of ways to generate cash despite the fact that they have so many billions of dollars of inventory to sell. After doing the math, we realize that actually have a negative yield on their overstated backlog of 1,269 homes. What does this mean? It means that they are going to closing faster than they are lining up people to close. The average time to go from contract signing to closing takes 45 to 90 days. Let’s use an average of 75 days (appraisal, title, approval, insurance, etc.). At their current closing rate and due to a lack of demand for their product, they will run out of customers to close properties with approximately 83% through next quarter, or approximately 75 days from the publication of their quarterly results (9/25/07). Let me state this again, Lennar will run out of closings. Closings are the only way they have to generate cash! To put this into perspective, by the time someone who signs a contract with Lennar last week to buy a house gets to closing, Lennar’s bankers and loan holders should be aggressively asking for their money back (if they have any sense). To put this in further perspective, assume Lennar makes it through next quarter without the banks calling in their debt. Lennar’s new orders are only 5,804 strong, and they are expecting a 32% cancellation rate off of that. So 68% of 5,804 is (let me pull out my calculator…) 3,947 orders into backlog. Lennar closes 7,636 per quarter. Soooo, even if they do somehow miraculously power through this upcoming quarter with no cash, generated at pure negative cash draw, they will have no customers to sell to before half of the next quarter is over. That is what their own numbers reveal! That is why the bankruptcy score diagrammed above states DISTRESSED! That is why Citibank’s homebuilder analyst is out of his damn mind. Does Citibank do any work for the homebuilders? Hmmm! I wonder??? I doubt that I am just that smart and they are just that dumb. This is the situation of the nation’s largest homebuilder, and there are many who are in worst shape. Since Lennar is the biggest (and probably one of the most proactive in managing inventory), you should be expecting worse from many others.

Next up, I will analyze as many of the public builders that I have positions in that I can, and create a builder bankruptcy list.

Comments

[Neil C]

Reggie,

I'm from the UK, and looking at UK housebuilders. They are looking about a year behind the US, in their charts, or about half way to the bottom BUT.... having been through a few balance sheets they actually look pretty good to me. They have very little debt (e.g. 20%), and basically seem to be virtually debt-free land banks. I think the land bank situation in the UK actually IS different from that in the US (although I don't know the US market well enough) due to high relative population density in the UK and restrictive planning regulations.

I also think that, with housing likely to soften about now in the UK (it has started already in the regions) we are not far away from the first rate cuts. Having lived on rising house prices (our bubble is worse than yours)the government will do anything to stop a price collapse. This makes the current price weakness a way of getting UK building land for historical cost (well below current values).It depends if you see this land as a scarce resource. In the UK, I think it is, unless the government opens up vast new tracts for building. But as they seem to "work closely" (how typical) with the larger housebuiders, I don't see a massive collapse in UK building land prices as likely. For these reasons I suspect that some of the UK builders may actually be worth a "Warren Buffet" style value punt about now. Even so, I suspect that sentiment will keep dragging the share prices lower share prices for a while, apart from the odd vicious rall, but I'm tempted to dip my toe in!

Or am I looking at a typical value trap?

Regards,

Neil

[Reggie]

I've started researching the European and central/south American housing markets but do not have enough information to cast an opinion publicly. I will soon, though.

If it turns out like the US markets, where the shares of the builders are being used as trading oppurtunities that have decoupled from the fundamentals from time to time, then their may be oppurtunity there. Once I get over to Europe with all of my resources I will post on my positions and findings.

[Rob Dawg]

If Lennar is bad, Beazer must be worse. From what I can deduce from the way you appear to be ranking LEN then BZH should be downright alarming. They appear out of cash, deep in debt, a small fish, and didn't even participate much in the recent stock pop.

[Reggie]

Well, let's put it this way. If I don't hurry to find the time to analyze BZH before bankruptcy, I may lose my oppurtunity to do so.

If I lose my oppurtunity, then I will have other oppurtunities since Beazer's asset devaluation as a result of failure will devalue everyone else, causing a chaing reaction.

Those affordable homes are on thier way, one way or the other.

[jeff]

Reggie:

I have a short positio in KBH. I feel this is a great short because they are in all of the worst hit areas of the country i.e. FL, CA, NV. Their market is the lower price point aspirational buyer who is the buyer being hurt most. KBH is in bed with CFC and actually spoke about their association with Tangelo proudly in the last conference call. Do they read the paper? They are currently trading at 1 time their embelished book value ( a significant premium to other HB's right now). They have not yet taken any impairment for their 500mm JV in Vegas that they bought in the height of the market in 05'. God only knows how many other impairments they have not come clean with--yet. If impairments were marked to market today, this stock could concievably be selling at 1 1/2-2 time book right now. Builders historically have traded at .5 book at the bottom; and we are not even there yet. By my estimation, this stock should be valued at about $10.00 if you were to adjust book properly and the stock traded at the P/B multiple that these times suggest.

Of course, in addition to Stephen Kim, that idiot Cramer has been pumping this stock unmercifly; probably to help get some of his hedge buddies out of this POS into the hands of retail bagholders. He claims that since the sale of their French JV that KBH's balance sheet is "impecable"...Yes, "impecable" because he claims they have 1 billion in cash. Of course he ignores the elephant in the room; a HUGE cash burn from here. I'd be curious to get your view on KBH.

[Reggie]

I see you have done your homework, and I noticed how much Cramer (whom I just saw the other day walking down the street, this guy is literally a celebrity now - good for him) has been pushing KBH as well. I concur with your points wholeheartedely. KBH has no other subsidiaries to sell, so they better have raised some cash (especially since it seems that they can't sell houses), and they seem to have a higher cash burn rate than many other of their peer group. They were one of the first to actually generate operating losses, outside of the actual impairmant charges. This is bad, for things are getting worse, not better. The fact that they got rid of thier mortgage arm is actually a big plus, not a minus for I feel the mortgage subsidiaries are going to hurt the homebuilders a lot. The fact that they chose CFC to parnter with as a replacement really doesn't make any sense, though. Literally, out of the frying pan and into the fire! Homebuilders created mortgage arms to grow veretically, and cut out the middleman. They make more money when they sell the mortgage. Since CFC is in a tight position, I assume they made KBH an offer they can't refuse. It just doesn't sit tight with me though, two companies fighting insolvency and bad press partnering with each other!!!

I hear KBH is aggressively selling land as well. How well this works for them remains to be seen. I will get around to posting my work on KBH as well.

Just for the record, I cannot actually give advice on this blog, but I can and do share my opinion.

[Reggie]

I posted this on another blog in response to someone suggesting a white knight coming in to save a builder. I think Kervorkian, or one of the big wigs came in to buy SPI and offered them about $20 per share earlier this year. It was refused by the board, and the stock is trading in the low single digits now. It appears that the white knight had rose colored glasses on!

It is highly unlikely anyone is going to buy a homebuilder out right now. Currently, there is simply no economic need for this industry. The last thing anybody needs now is more houses! The only way these companies' assets will move is with a very, very sharp haircut to the equity holders, and most likely a decent one to the debt holders as well - hence the bankruptcy scenario. Their assets are way overpriced, and way underwater, and they have too much of them.

These rumors about buyouts simply don't take into consideration the macro view and the fundamentals. Strategically, there is a fundamental flaw in the public homebuilder business model, as we will soon see.

I think the under appreciated scenario here is what happens if and when a decent sized builder goes bust. All of those billions of dollars of overpriced assets that aren't moving due to the inelasticity of demand suddently get the well deserved haircut, get marked to market, and devalues the whole shebang. Raw land, finsished and, houses, entire communities, mortgages, homebuilder publicly traded equity, debt, etc.

There are a lot of big banks, big home builders, and other investors holding debt, equity and land at infated values and are continuing to hold these assets at unrealistically high values because they haven't been "marked to market". If a big homebuilder goes bust, vulture investors will come in and scoop up all they can for 18 cents on the dollar and then dump them back out onto the market for whatever the market will buy them for, as long as it is more than 18 cents on the dollar, which it may be. The vulture investor makes money, the market reaches equilibrium (all of those potential homeowners now have affordable homes reset in price down from the housing bubble) and the risk premium of mortgage securities are now added back to the yield of said securities. The downside is, instant and significant loss to everyone who held these assets marked to bubble, in lieu of marked to market.

What do you think will happen to the value of the land that Lennar owns (several billion dollars), the value of the mortgages that are in Lennar's pipeline (they did over $10 billion in '06), and the value of the finished houses and lots in the communities they are currently trying to sell if they were to go bankrupt? You see, if they go bankrupt, it is a fire sale. The stuff just doesn't disappear. Someone will try and go in and buy it at a STEEP discount. Once they get those assets at cents on the dollar, they will flip them back onto the market, prompting sales and profits for the vulture investor, but big losses for the other builders, banks and homeowners who don't have the instant pennies on the dollar cost basis, all due to the due to the further devaluing of their inventory.

Comps drop, and the game begins anew at totally different price point. Homeowners comparable values drop, hence dropping their wealth, banks collateral shrinks, their REO valuations drop, leveraged derivative products have even less underlying collateral than before, etc. The builders drop in inventory valuations may trip covenant triggers, causing even more distress as the banks consider calling in debt.

The same scenario with mortgages. Suppose I pick them up cheap and start selling them at a big discount but still profitable to me. Citibank, Merrill, Countrywide, and everyone else who says the worst is behind us will have to mark their debt to market (market is now lower after my fire sale transactions bounce back on the market). Don't even let me get started on the raw land.

That is the background behind my statement of the widespread devaluation. The market can get back to equilibrium a lot faster than many realize.

[Reggie]

KBH has just released their 10Q, and by my off the cuff calculations they are burning $270 million per quarter in cold hard cash. This is excluding all writedowns, impairments and goodwill hits. This means their core business is losing money at a rate of $1 billion dollars per year, plus carrying overvalued inventory that must be further written down. I will have a model of KBH in two weeks to map this all out.

[jeff]

Reggie:

Thanks for the update on KBH. I look forward to your BK model. What maturity puts do you think makes the most sense on KBH? Are there any other HB's that you like better than KBH to short?

[Reggie]

Unfortunately, I can't give advice publicly but I will put blog posts up concerning various builders, lenders, insurers and others involved in boom, bust and bling:-)

[Keith Dager]

Reggie... I appreciate your blog and hard work, but what data did you use to arrive at Lennar's 1.84 Z-Score? My run through of the Yahoo Finance income statement and balance sheet data for their quarter ending 8/31/07 produced a Z-Score of 2.37 for Lennar. One of us has to be wrong. I don't mind being wrong if I can learn from you where I miscalculated.

[Reggie]

Hopefully, your answers can be found in the VooDoo article that was published last week. To make a long story short, you cannot accurately calculate a company's finances by going through aggregation sources such as Yahoo Finance, for there are too many ambiguities. You have to dig up the SEC filings themselves and run through the footnotes (a lot more work, though, which is what makes yahoo type services so popular). That's not saying that I can't be wrong, either. There are a hundred reasons why we came up with different answers. I could have made mistake, you could have made a mistake, we could have used different versions of the altman's formula (notice how I refined the calculation every time I did it - causing it waiver ever so slightly), or your use of Yahoo Finance could have led to inaccurate data input (my guess).

2.37 and 1.84 give off the same message according to the z score, though - Lennar is in distressed territoty. If you read altman's missives, 2.67 was the level that you should be wary of.

[homes for sale newport coast]

Actually, someone will be annoucing soon anyway, it is just a matter of who has the least fight left in them.